Fannie and Freddie auctions raise questions about CDSs

Fannie Mae and Freddie Mac were taken into conservatorship by the US Treasury on September 7, an event that constitutes a technical default under standard CDS documentation.

Both firms were common investment-grade reference credits within synthetic collateralised debt obligations (CDOs) and credit derivatives indexes. Together with credit event auctions on CDSs referencing Lehman Brothers on October 10, they represent the biggest-ever test of the International Swaps and Derivatives Association’s cash settlement auction protocol.

Isda drew up a list of Fannie Mae and Freddie Mac’s deliverable obligations at the end of September. This excluded zero-coupon notes issued by the government-sponsored enterprises, although callable zero-coupon bonds and range accruals were included.

Michael Hampden-Turner, European head of CDO research at Citi in London, said the decision to include these instruments as deliverable obligations led to lower expectations of recovery rates. During cash-settlement auctions, market participants generally quote spreads on the debt obligations of defaulted entities that are the cheapest to deliver. “The result was that everybody in the auction expected it to end with a recovery rate lower than for the bonds,” he said.

Some of these notes are trading in the mid-80s range, whereas the senior and subordinated obligations of the two mortgage lenders are trading at closer to 97-98%, according to Citi.

In the event, the final price for Fannie Mae’s senior and subordinated obligations was set at 91.51% and 99.9%, respectively, while Freddie Mac’s senior and subordinated obligations was fixed at 94% and 98%, respectively.

“The purpose of cash-settling CDSs is to provide a result that closely follows where the bulk of the debt trades, so 97-98% would have been a better result. This raises questions about the CDS market with the Lehman Brothers auction coming on Friday,” said Hampden-Turner.

Even in spite of the inclusion of a broad range of deliverable obligations, final prices came in at the high end of some analyst expectations, thanks to the high proportion of market participants opting for cash settlement.

“In the end, there weren’t enough physical assets being delivered, so the price was generally higher than expected,” remarked Hampden-Turner. In particular, a lack of market participants willing to physically deliver subordinated bonds produced the unusual outcome of subordinated paper settling higher than senior paper.

In cash-settled CDS transactions, protection sellers are required to pay the par value of defaulted bonds to protection buyers, minus the recovery rate. A higher-than-expected recovery rate is therefore good for protection sellers, including many traditional structured credit investors.

Sivan Mahadevan, New York-based global head of credit derivatives and structured credit research at Morgan Stanley, observed: “This is good for traditional credit investors who had a collection of these names in indexes or CDO tranches, and it’s better than the market was predicting last week.”

See also: Auction determines settlement price for Fannie and Freddie
CDS spreads on US banks tighten
Isda prepares to settle CDSs on failed banks

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